Policy paper

Statement of Practice 3 (2002)

Published 30 September 2002

Statement of Practice 3 (2002)

Introduction

1. This Statement of Practice sets out HM Revenue and Customs (HMRC) view on the tax treatment of transactions in futures and options of the sorts defined in Taxation of Chargeable Gains Act (TCGA) 1992 section 143 and relating to shares, securities, foreign currency or other financial instruments. It does not apply to contracts falling within the financial instruments legislation in Finance Act (FA) 1994 Part 4 Chapter 2 or, for accounting periods beginning on or after 1 October 2002, derivative contracts falling within FA 2002 Schedule 26. The principles set out are of relevance to:

• UK residents such as unauthorised unit trusts, charities and others (including companies) which either do not trade or whose principal trade is outside the financial area and
• non-resident collective investment vehicles (whether open or closed-ended), pension funds and others (including companies) which either do not trade or whose principal trade is outside the financial area

2. This statement does not apply to approved pension schemes, whose profits from futures and options are generally exempt from tax.

3. In relation to companies, this statement will be applicable for accounting periods beginning on or after 1 October 2002 and only in relation to financial futures and options where the underlying subject matter is shares, a holding in an authorised unit trust, or a security to which FA 1996 section 92 or 93 applies.

4. ‘Financial futures’ is a wide term. It includes:

• contracts for future delivery of shares, securities, foreign currency or other financial instruments
• contracts that are settled by payment of cash differences determined by movements in the price of such instruments (including contracts where settlement is based on the application of an interest rate or a financial index to a notional principal amount), as well as contracts settled by delivery, and
• both exchange traded and over the counter contracts

5. ‘Options’ includes:

• both exchange traded and over the counter options and
• options that are settled by a cash payment between the parties, as well as those that provide for delivery
• warrants

Relevance of trading

6. Taxes Act (TA) 1988 section 128 and TCGA 1992 section 143 provide, broadly, that transactions in financial futures and options will be treated as capital in nature unless they are regarded as profits or losses of a trade. It is immaterial for this purpose whether the profits of the trade are taxed under Case I of Schedule D or otherwise (see HSBC Life (UK) Ltd and others v Stubbs and others (2001) STC (SCD) 9).

7. If, under normal statutory and case law principles, profits or losses fall to be treated as trading in nature then TA 1988 section 128 and TCGA 1992 section 143 have no application to those profits or losses. It is therefore necessary first to determine whether or not the taxpayer’s transactions in futures and options give rise to trading profits or losses.

8. Whether or not a taxpayer is trading is a question of fact and degree, to be determined by reference to all the facts and circumstances of the particular case. However, HMRC consider that an individual is unlikely to be regarded as trading as a result of purely speculative transactions in financial futures or options. Transactions in financial futures or options by a company may be either trading or capital in nature.

9. However, a financial futures or options transaction which is clearly ancillary to a trading transaction on current account will give rise to trading profits or losses. In contrast, a financial futures or options transaction which is clearly ancillary to a transaction which is not a trading transaction on current account will be capital.

10. A financial futures or options transaction that is not clearly ancillary to another transaction may be a trading transaction in its own right. Whether this is so will depend on all the facts and circumstances of the case. Consideration will be given to what are known as the ‘badges of trade’. In such a case, intention and frequency are important. The transaction will not necessarily be regarded as trading. It may well be regarded as capital in nature, depending on all the facts and circumstances.

Elimination or reduction of risk

11. In determining whether a financial futures or options transaction is ancillary to another transaction the following points are relevant:

• there must be another transaction
• that other transaction must already have been undertaken, or there must be the intention to undertake it in the future
• the financial futures or options transaction is ancillary to the other transaction if the intention is to eliminate or reduce risk, or to reduce transaction costs, in respect of that other transaction
• the financial futures or options transaction must be economically appropriate to the elimination or reduction of risk, or to the reduction of transaction costs
• the financial futures or options transaction may be ancillary to more than one other transaction and more than one financial futures or options transaction may be ancillary to another transaction
• it may be necessary to enter into new financial futures or options transactions or to terminate existing ones to reflect changes in the value of the assets or liabilities resulting from the other transaction

12. These points apply to long and short positions and apply whether the futures position is closed out or held to final maturity, or, in the case of an options position, closed out, exercised or held to final expiry.

13. In considering whether the financial futures or options transaction is ‘economically appropriate’ to the elimination or reduction of risk, HMRC take the view that:

• the transaction must be one which, by virtue of the relationship between fluctuations in its price and any fluctuations in the value of the other transaction, may reasonably be expected to be appropriate to be used in order to eliminate or reduce risk
• the use of a financial futures or options transaction based on an index of some sort is not regarded as precluding the existence of such a reasonable expectation
• it would not normally be expected that the amount of the principal on which the financial futures or options transaction is based should significantly exceed the principal of the other transaction

14. There may be cases where a financial futures or options transaction is entered into in order to eliminate or reduce risk, but the other transaction then falls away (or the intention to enter into the other transaction is abandoned). If the financial futures or options transaction is closed out within as short a period as is practicable after this happens the transaction will continue to be treated in accordance with the principles outlined above. If, however, the futures or options transaction is not closed out at that time it may be arguable that any profit or loss arising subsequently is of a trading nature. In practice, where the taxpayer is not otherwise trading, HMRC would not normally take this point in view of the taxpayer’s original intention.

Base currency

15. The question may arise as to whether a financial futures transaction to buy or sell currency forward is ancillary to a capital transaction. In many cases the answer will be dependent on which currency is the taxpayer’s base currency (that is, the currency in which value is measured).

16. For UK resident taxpayers the base currency will normally (but need not necessarily) be sterling. In determining whether there is a non-sterling base currency, HMRC will have regard to factors such as:

• the currency in which accounts are prepared
• the currency in which share capital is denominated and
• evidence of the taxpayer’s intentions (for example in a published prospectus)

Examples

17. The following examples illustrate the above and are not intended to cover every situation that may arise. In the first 8, the assets concerned are held or will be acquired as investments and the financial futures or options transactions would normally be treated as capital (on the assumption that the condition in the first bullet in paragraph 13 above is fulfilled):

• a taxpayer which holds gilts sells gilt futures to protect the value of its capital in the event of a fall in the value of gilt-edged securities generally
• a taxpayer which intends to purchase an asset does so in 2 stages, by (a) purchasing a foreign currency future in advance of the purchase of an asset denominated in that currency, or (b) purchasing an option in respect of an underlying asset as a first step towards the acquisition of the asset itself
• a taxpayer which holds a broadly based portfolio of UK equities sells Financial Times Stock Exchange (FTSE) 100 index futures or purchases FTSE 100 index put options to protect against the risk to the value of the portfolio from a fall in the market
• a taxpayer holding foreign currency assets acquires a futures or options contract to reduce the risk of a fall in the value of the foreign currency assets (as measured in the taxpayer’s base currency)
• a taxpayer which is intending to acquire a broad range of UK securities buys a call option on an FTSE 100 index to protect against a rise in the price of the securities in the period before they can be acquired
• a taxpayer sells or buys options or futures as an incidental and temporary part of a change in investment strategy, (eg, changing the ratio of gilts and equities)
• a taxpayer either has existing liabilities (eg, loans) denominated in a currency other than its base currency or expects to incur such liabilities (eg, as a result of an intention to borrow to acquire investments) and uses a futures or options contract to protect itself against a rise in the currency in which the liabilities are or will be denominated
• a taxpayer whose base currency is the dollar holds yen-denominated securities and, in order to eliminate the perceived risk of a fall in their value, enters a forward contract to sell for dollars an amount of yen equivalent to the yen value of the securities - (this is because the forward contract may be regarded as ancillary to the transaction in securities)

The next 2 examples involve financial futures or options transactions which would be treated as trading (because they would be ancillary to other trading transactions):

• a taxpayer’s futures or options transactions are incidental to its trading activity, for example, a manufacturer entering into transactions to reduce the risk of fluctuations in the price of raw materials - (the profits and losses from these transactions would be taken into account as part of the profits and losses of the trade)
• a taxpayer has borrowed money at a floating rate of interest, for trade purposes, and enters into an interest rate future or option with a view to protecting itself against rises in interest rates - (receipts or payments relating to the future or option would be taken into account as trading income or expenditure on current account, this is because the future or option is ancillary to a trading transaction ie, the payment of interest for trade purposes - given this, it does not matter whether or not the borrowing is on capital account)

Finally, the 3 examples below illustrate circumstances where a taxpayer’s transactions in financial futures and options will not generally be regarded as ancillary to another transaction. It is therefore necessary to look at the transactions in their own right to see whether they are to be treated as capital or as trading transactions:

• a taxpayer uses futures and options in conjunction with a holding of cash, bonds etc so as to create synthetic assets - (on the assumption that, in such circumstances, the financial futures or options transactions cannot all be shown to be ancillary to other transactions)
• a taxpayer uses futures and options to take a position in a currency in which it does not have a portfolio, and has no intention of acquiring a portfolio, so as to create an exposure to fluctuations in that currency by reference to its base currency
• a taxpayer whose base currency is sterling holds yen-denominated securities and, in order to eliminate the perceived risk of a fall in their value, enters a financial futures transaction to sell for dollars an amount of yen equivalent to the yen value of the securities - there is no intention of selling the yen-denominated securities and using the proceeds to acquire dollar-denominated securities - (the effect of the financial futures transaction is to increase the taxpayer’s dollar exposure and to decrease its yen exposure)